Financial engineering can be damaging to the public and private sectors

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The last financial crisis taught us some of the risks to the economy when “financial engineering” gets out of hand. Real estate developers had borrowed almost all of their capital from banks, and builders also relied on banks for most of their working capital. In each case, the owners or shareholders had little risk for their own money, as most of it came from the banks.

In turn, the banks had reduced their available capital, thereby maximizing their lending.

It was a house of cards, as risky businesses relied on each other to stand up.

When builders and real estate developers made big losses, they had no capital available: instead, they defaulted on their bank loans, finding themselves insolvent. Faced with this avalanche of defaults, the banks are also insolvent. It was up to the taxpayer to bail out the banks.

The rush to depend on loans rather than equity was driven by two different factors. A desire on the part of investors to maximize returns on their holdings, while undervaluing risk, and an asymmetry in corporate taxation that affects most developed economies.

If the owners of a business reduce their stake by borrowing to replace their own equity, they may not significantly affect the total surplus earned by the business. However, if the interest rate is low enough, they end up earning the same profit with a much lower stake. This can make it much more profitable for the investor.

Because the investor’s liability is limited to his participation in the company, what he risks losing is capped: he increases the odds of his bet, accepting a higher risk, while limiting the size of his bet. bet.

This is called corporate leverage, and because of the increased risk, borrowing is called junk bonds, usually commanding a high interest rate.

The problem with the run-up to the crisis in the mid-2000s was that banks massively understated the risk they were taking on. This dramatically increased their short-term profits as they increased their loans, but the consequences were catastrophic for the shareholders of the banks, and ultimately for the taxpayer.

Tax efficient

A second factor determining debt financing is that the corporate tax system favors it. Taxable profits are calculated on the basis of the residual surplus after payment of interest. Thus, if a company pays interest to a subsidiary outside Ireland, that interest will not be taxed in Ireland. Only profit after interest will be taxed.

This principle is generally applied in developed economies. It encourages companies to borrow more and rely less on equity, which increases the risk of default in the face of an unexpected downturn.

It would make sense to reform the corporate tax system and treat return on equity and debt symmetrically. However, such a change might be difficult to implement unilaterally.

For most companies, where they are not essential to the economy, their owners are free to structure their capital as they see fit. If they go bankrupt, that’s a problem for lenders, shareholders and employees. As long as the business is not systemically important, like banks, this is usually not a problem for the economy.

However, for banks, regulations have been reformed, forcing them to act much more cautiously. As a result, at the start of the Covid crisis, they had a much larger layer of insulating capital to protect them.

Utilities

Where unregulated financial engineering can also have serious negative economic effects is in the case of utilities, such as water, electricity, airports and telecommunications. They are often natural monopolies, providing vital services to the economy. However, if they rely too heavily on the loan, they will increase the risk. In turn, if shareholders’ capital is insufficient, they may not be able to borrow to invest in the network.

This has been a problem with the telecommunications network. During the privatization of Telecom Éireann (Eir), the new owners borrowed heavily, reducing shareholders’ capital so that they ultimately could not finance new investments.

The regulator should have had the power to prevent this in the late 1990s. If the company had been regulated in this way, we may never have needed a national broadband plan.

The capital structure of Crown corporations, such as BSE, is also important if they are to expand their vital services. They must be profitable to maintain the state’s equity and allow it to borrow to invest in our future.

Improper financial engineering can be detrimental to both the public and private sectors.

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